CHAPTER 8
INVENTORIES: MEASUREMENT
Overview
The next two chapters continue our study of assets by investigating the measurement and reporting
issues involving inventories and the related expense—cost of goods sold. Inventory refers to the
assets a company (1) intends to sell in the normal course of business, (2) has in production for future
sale, or (3) uses currently in the production of goods to be sold.
Learning Objectives
LO8-1 Explain the difference between a perpetual inventory system and a periodic inventory
system.
LO8-2 Explain which physical quantities of goods should be included in inventory.
LO8-3 Determine the expenditures that should be included in the cost of inventory.
LO8-4 Differentiate between the specific identification, FIFO, LIFO, and average cost methods
used to determine the cost of ending inventory and cost of goods sold.
LO8-5 Discuss the factors affecting a company’s choice of inventory method.
LO8-6 Understand supplemental LIFO disclosures and the effect of LIFO liquidations on net
income.
LO8-7 Calculate the key ratios used by analysts to monitor a company’s investment in inventories.
LO8-8 Determine ending inventory using the dollar-value LIFO inventory method.
LO8-9 Discuss the primary difference between U.S. GAAP and IFRS with respect to determining
the cost of inventory.
Lecture Outline
Part A: Recording and Measuring Inventory
I.
Types of Inventory
A. Inventory for a wholesale or retail company consists of goods purchased in finished form
for resale. Inventory for a manufacturing company includes raw materials, work in
process, and finished goods. (T8-1)
B. For a manufacturing company, the costs of raw materials, direct labor, and manufacturing
overhead flow into work in process, then to finished goods when the manufacturing
process is completed, and finally to cost of goods sold when goods are sold. (T8-2)
II. Perpetual Inventory System (T8-3)
A. A perpetual inventory system continuously tracks both changes in inventory quantity and
inventory cost.
B. Inventory is debited when merchandise is purchased or returned by a customer, and
credited when merchandise is sold or returned to a supplier.
C. An important control feature of a perpetual system is that it is designed to track inventory
quantities from their acquisition to their sale.
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III. Periodic Inventory System (T8-4)
A. A periodic inventory system adjusts inventory and records cost of goods sold only at the
end of each reporting period.
B. Merchandise purchases, purchase returns, purchase discounts, and freight-in are recorded
in temporary accounts.
C. Purchases plus freight-in less returns and discounts equals net purchases.
D. The period's cost of goods sold is determined at the end of the period by combining the
temporary accounts with the inventory account:
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold
IV. A Comparison of the Perpetual and Periodic Inventory Systems
A. The impact on the financial statements of choosing one system over the other generally is
not significant.
B. The perpetual system provides more timely information but is more costly to implement.
C. The periodic inventory system is less costly to implement during the period but usually
requires a physical count before ending inventory and cost of goods sold can be
determined.
V. What Is Included in Inventory?
A. Generally, physical quantities included in inventory consist of items in the possession of
the company. (T8-5)
1. For goods in transit, ownership depends on whether the merchandise is shipped f.o.b.
shipping point, or f.o.b. destination.
2. Goods held on consignment are included in the inventory of the consignor until sold by
the consignee.
3. A company includes in inventory the cost of merchandise it anticipates will be
returned.
B. Expenditures necessary to bring inventory to its condition and location for sale (or use for
raw materials) are included in inventory cost. (T8-6)
1. Freight-in paid by the purchaser is included in inventory cost.
2. Shipping charges on outgoing goods are not included in the cost of inventory. They
are reported in the income statement either as part of cost of goods sold or as an
operating expense, usually among selling expenses.
3. Purchase returns represent reductions in net purchases.
4. Purchase discounts represent reductions in the amount to be paid if remittance is made
within a designated period of time. The purchaser can record purchase discounts using
either the gross method or the net method (T8-7)
C. Comprehensive example comparing perpetual and periodic systems. (T8-8)
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VI. Inventory Cost Flow Assumptions
A. Regardless of the system used, it's necessary to assign dollar amounts to physical quantities
of goods sold and goods remaining in ending inventory. (T8-9)
1. The specific identification method matches each unit sold or each unit on hand at the
end of the period with its actual cost. The method is not feasible for most inventories.
2. Most companies use cost flow assumptions to determine cost of goods sold and ending
inventory. (T8-10)
a. The average cost method assumes that items sold and items in ending inventory
come from a mixture of all the goods available for sale.
(T8-11)
b. The first-in, first-out (FIFO) method assumes that items sold are those that were
acquired first. Ending inventory consists of the most recently acquired items. (T812)
c. The last-in, first-out (LIFO) method assumes that items sold are those that were
most recently acquired. Ending inventory consists of the items acquired first. (T813)
B. The financial statement effect of using the different methods depends on the direction of
any change in the unit cost of goods. (T8-14)
C. There are a number of factors that motivate company management to choose one method
over another.
1. A company is not required to choose an inventory method that approximates actual
physical flow.
2. Many companies choose LIFO to reduce income taxes in periods when prices are
rising.
a. The IRS LIFO conformity rule requires that if a company uses LIFO to measure
its taxable income, LIFO also must be used to measure income reported to
investors and creditors.
b. The LIFO conformity rule permits LIFO users to present designated supplemental
disclosures that report in a note the effect of using another method on inventory
valuation rather than LIFO. (T8-15)
3. Proponents of LIFO argue that it results in a better match of revenues and expenses.
a. However, the use of LIFO could result in an unrealistic ending inventory balance.
b. A decline in inventory quantity results in LIFO liquidation profit in periods of
rising costs. (T8-16)
4. International Financial Reporting Standards do not permit the use of LIFO. (T8-17)
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Decision Makers’ Perspective—Financial Analysis
A. A company should maintain sufficient inventory quantities to meet customer demand
while at the same time minimizing inventory ordering and carrying costs.
B. Analysts should make adjustments when evaluating companies that use different inventory
methods. Supplemental LIFO disclosures can be used to convert LIFO inventory and cost
of goods sold amounts. (T8-18)
C. Two important ratios used by analysts in assessing profitability are: (T8-19)
1. The gross profit or gross margin ratio, computed by dividing gross profit (sales less
cost of goods sold) by net sales, indicates the percentage of each sales dollar available
to cover expenses other than cost of goods sold and to provide a profit.
2. The inventory turnover ratio, computed by dividing cost of goods sold by average
inventory, is designed to evaluate a company's effectiveness in managing its
investment in inventory.
Part B: Methods of Simplifying LIFO
I.
LIFO Inventory Pools
A. Unit LIFO can be costly to implement and can lead to LIFO liquidations.
B. The objectives of using LIFO inventory pools is to (1) simplify recordkeeping by grouping
inventory units into pools based on physical similarities and (2) to reduce the risk of LIFO
layer liquidation.
C. The average cost for all of the pool purchases during the period is applied to the current
year's LIFO layer.
II. Dollar-Value LIFO
A. The dollar-value LIFO (DVL) method extends the concept of inventory pools by
allowing a company to combine a large variety of goods into one pool. Most LIFO
applications are based on this approach. (T8-20)
B. Inventory is viewed as a quantity of value instead of a physical quantity of goods. Instead
of layers of units from different purchases, the DVL inventory pool is viewed as
comprising layers of dollar value from different years.
C. A DVL pool is made up of items that are likely to face the same price change pressures,
not items with physical similarities.
D. Under DVL, we determine whether a new LIFO layer was added by comparing the ending
dollar amount with the beginning dollar amount after deflating inventory amounts to base
year with the aid of a cost index. (T8-21)
E. The starting point in DVL is determining the current year's ending inventory valued at
year-end costs. The DVL estimation technique then employs three steps: (T8-22)
1. Step 1 converts ending inventory valued at year-end cost to base year cost.
2. Step 2 identifies the layers of ending inventory and the years they were created.
3. Step 3 converts each layer's base year cost to layer year cost using the cost index for
the year it was acquired.
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PowerPoint Slides
A PowerPoint presentation of the chapter is available at the textbook website.
Teaching Transparency Masters
The following can be reproduced on transparency film as they appear here, or
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TYPES OF INVENTORY
 Merchandising Companies

Merchandise inventory — Goods purchased in finished
form for resale.
 Manufacturing Companies

Raw materials — The cost of components purchased
from other manufacturers that will become part of the
finished product.

Work in process — The products that are not yet
complete. It includes the cost of raw materials, the cost
of labor that can be directly traced to the goods in
process, and an allocated portion of other manufacturing
costs, called manufacturing overhead.

Finished goods — Once the manufacturing process is
complete, the costs accumulated in work in process are
transferred to finished goods.
T8-1
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INVENTORY COST FLOW FOR A
MANUFACTURING COMPANY
Raw
Materials
Work in
Process
Finished
Goods
-------------------------
-----------------------
----------------------
(1) $XX
$XX (4) 
$XX

$XX (7) 
$XX
Cost of
Goods Sold
-----------------------
$XX (8) 
$XX
Direct Labor
-------------------------
(2) $XX
$XX (5) 

Manufacturing
Overhead
-------------------------
(3) $XX
$XX (6) 

(1) Raw materials purchased
(2) Direct labor incurred
(3) Manufacturing overhead incurred
(4) Raw materials used
(5) Direct labor applied
(6) Manufacturing overhead applied
(7) Work in process transferred to finished goods
(8) Finished goods sold
Illustration 8-2
T8-2
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PERPETUAL INVENTORY SYSTEM

A perpetual inventory system continuously records both
changes in inventory quantity and inventory cost.
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company begins 2013 with merchandise inventory of $120,000
on hand. During 2013 additional merchandise is purchased on
account at a cost of $600,000. Sales for the year, all on account,
totaled $820,000. The cost of the soft drinks sold is $540,000.
Lothridge uses the perpetual inventory system to keep track of
both inventory quantities and inventory costs. The system
indicates that the cost of inventory on hand at the end of the year
is $180,000.
The following summary journal entries record the inventory
transactions for the Lothridge Company:
2013
Inventory........................................................... 600,000
Accounts payable.........................................
600,000
To record the purchase of merchandise inventory.
2013
Accounts receivable ......................................... 820,000
Sales revenue ...............................................
820,000
To record sales on account.
Cost of goods sold ........................................... 540,000
Inventory......................................................
540,000
To record the cost of sales.
Illustration 8–3
T8-3
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PERIODIC INVENTORY SYSTEM

A periodic inventory system adjusts inventory and records
cost of goods sold only at the end of each period.
Cost of goods sold equation:
Beginning inventory + Net purchases - Ending inventory = Cost of goods sold
The Lothridge Wholesale Beverage Company purchases soft drinks from
producers and then sells them to retailers. The company begins 2013 with
merchandise inventory of $120,000 on hand. During 2013 additional
merchandise was purchased on account at a cost of $600,000. Sales for the
year, all on account, totaled $820,000. The cost of the soft drinks sold is
$540,000. Lothridge uses the periodic inventory system. A physical count
determined the cost of inventory at the end of the year to be $180,000.
The following summary journal entries record the inventory transactions for
2013. Of course, each individual transaction would actually be recorded as
incurred:
2013
Purchases.......................................................... 600,000
Accounts payable ........................................
600,000
To record the purchase of merchandise inventory.
2013
Accounts receivable ......................................... 820,000
Sales revenue ..............................................
820,000
To record sales on account.
NO ENTRY IS RECORDED FOR THE COST OF INVENTORY SOLD
Illustration 8-4
T8-4
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PERIODIC INVENTORY SYSTEM
(continued)
Cost of goods sold for 2013 is determined and recorded as
follows:
Beginning inventory
Plus: Purchases
Cost of goods available for sale
Less: Ending inventory (per physical count)
Cost of goods sold
$120,000
600,000
720,000
(180,000)
$540,000
The following journal entry combines the components of cost of
goods sold into a single expense account and updates the balance
in the inventory account:
December 31, 2013
Cost of goods sold ................................................ 540,000
Inventory (ending) ................................................. 180,000
Inventory (beginning) .........................................
120,000
Purchases ..........................................................
600,000
This entry adjusts the inventory account to the correct period-end
amount, closes the temporary purchases account, and records the
residual as cost of goods sold.
T8-4 (continued)
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PHYSICAL QUANTITIES INCLUDED IN INVENTORY



Generally, physical quantities included in inventory consist of
items in the possession of the company.
Goods in transit

If the goods are shipped f.o.b. (free on board) shipping
point, then legal title to the goods changes hands at the
point of shipment when the seller delivers the goods to
the common carrier.

If the goods are shipped f.o.b. destination, the seller is
responsible for shipping and legal title does not pass
until the goods arrive at the customer's location.
Goods on consignment


Goods on consignment should be included in inventory
of the consignor even though not in the company's
physical possession. The consignor records a sale only
when the consignee sells the goods.
Sales Returns

A company includes in inventory the cost of
merchandise it anticipates will be returned.
T8-5
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EXPENDITURES INCLUDED IN INVENTORY


The cost of inventory includes all expenditures necessary to
bring inventory to its desired condition and location for sale.
This includes:

The purchase price of goods.

Freight charges on incoming goods borne by the
purchaser.

Insurance costs while the goods are in transit.

The costs of unloading, unpacking, and preparing
merchandise for sale.
Cost is reduced by purchase returns and purchase discounts.
T8-6
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PURCHASE DISCOUNTS
On October 5, 2013, the Lothridge Wholesale Beverage Company purchased
merchandise at a price of $20,000. The repayment terms are stated as 2/10, n/30.
Lothridge paid $13,720 ($14,000 less the 2% cash discount) on October 14 and the
remaining balance of $6,000 on November 4. Lothridge employs a periodic
inventory system.
The gross and net methods of recording the purchase and cash payment are
compared as follows:
Gross Method
October 5, 2013
Purchases*
Accounts payable
Net Method
October 5, 2013
Purchases*
Accounts payable
19,600
October 14, 2013
Accounts payable
14,000
Purchase discounts*
280
Cash
13,720
October 14, 2013
Accounts payable
Cash
13,720
November 4, 2013
Accounts payable
Cash
November 4, 2013
Accounts payable
Interest expense
Cash
5,880
120
20,000
20,000
6,000
6,000
19,600
13,720
6,000
* The inventory account is used in a perpetual system
Illustration 8-5

The gross method views discounts not taken as part of inventory cost.

The net method views discounts not taken as interest expense.
T8-7
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8-13
INVENTORY TRANSACTIONS —
PERPETUAL AND PERIODIC SYSTEMS
The Lothridge Wholesale Beverage Company purchases soft
drinks from producers and then sells them to retailers. The
company began 2013 with merchandise inventory of $120,000 on
hand. During 2013 additional merchandise is purchased on
account at a cost of $600,000.
Lothridge’s suppliers offer credit terms of 2/10, n/30. All
discounts were taken. Lothridge uses the net method to record
purchase discounts. All purchases are made f.o.b. shipping point.
Freight charges paid by Lothridge totaled $16,000. Merchandise
with a net of discount cost of $20,000 was returned to suppliers
for credit. Sales for the year, all on account, totaled $830,000.
The cost of the soft drinks sold is $550,000. $154,000 of
inventory remained on hand at the end of 2013.
The above transactions are recorded in summary form
according to both the perpetual and period inventory systems as
follows:
T8-8
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INVENTORY TRANSACTIONS —
PERPETUAL AND PERIODIC SYSTEMS
(continued)
Perpetual System
Inventory ($600 x 98%)
Accounts payable
Inventory
Cash
Accounts payable
Inventory
($ in 000s)
588
16
20
Accounts receivable
Sales revenue
830
Cost of goods sold
Inventory
550
No entry
Periodic System
Purchases
Purchases ($600 x 98%)
588
Accounts payable
588
588
Freight
Freight-in
16
Cash
16
Returns
Accounts payable
20
Purchase returns
20
830
16
Sales
Accounts receivable
Sales revenue
20
830
830
No entry
550
End of period
Cost of goods sold (below)
Inventory (ending)
Purchase returns
Inventory (beginning)
Purchases
Freight-in
550 <----------154
|
20
|
120
|
588
|
16
|
|
Supporting schedule:
Cost of goods sold:
Beginning inventory
Purchases
Less: Returns
Plus: Freight-in
Net purchases
Cost of goods available
Less: Ending inventory
Cost of goods sold
|
|
$120
|
$588
|
(20)
|
16
|
584
|
704
|
(154) |
$550 <--Illustration 8-6
T8-8 (continued)
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COST FLOW ASSUMPTIONS
The Browning Company began 2013 with $22,000 of inventory. The cost of
beginning inventory is composed of 4,000 units purchased for $5.50 each.
Merchandise transactions during 2013 were as follows:
Purchases
Date of
Purchase
Jan. 17
Mar. 22
Oct. 15
Totals
Units
1,000
3,000
3,000
7,000
Unit Cost*
$6.00
7.00
7.50
Total Cost
$ 6,000
21,000
22,500
$49,500
* includes purchase price and cost of freight.
Sales
Date of Sale
Units
Jan. 10
2,000
Apr. 15
1,500
Nov. 20
3,000
Total
6,500
Illustration 8-7
Beginning inventory
($22,000)
+
Purchases
($49,500)
\
Cost of goods
available
($71,500)
Cost of inventory
on hand at end of period
/
?
\
Cost of goods sold
during the period
/
?
Total ending inventory plus
cost of goods sold = $71,500
Illustration 8-7B
T8-9
© The McGraw-Hill Companies, Inc. 2013
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COST FLOW ASSUMPTIONS

The average cost method assumes that items sold and items
in ending inventory come from a mixture of all the goods
available for sale.

The first-in, first-out (FIFO) method assumes that items
sold are those that were acquired first. Ending inventory
consists of the most recently acquired items.

The last-in, first-out (LIFO) method assumes that items sold
are those that were most recently acquired. Ending inventory
consists of the items acquired first.

In a periodic system, ending inventory and cost of goods
sold are determined using one of the three cost flow
assumptions compared on the next slide:
T8-10
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COST FLOW ASSUMPTIONS
(continued)
AVERAGE COST
Cost of goods available for sale (11,000 units)
Less: Ending inventory (determined below)
Cost of goods sold (difference)
Cost of ending inventory:
$71,500
Weighted-average unit cost =
11,000 units
4,500 units x $6.50 = $29,250
$71,500
(29,250)
$42,250
=
$6.50
FIFO
Cost of goods available for sale (11,000 units)
Less: Ending inventory (determined below)
Cost of goods sold (difference)
Cost of ending inventory:
Date of
Purchase
Units
Unit Cost Total Cost
Mar. 22
1,500
$7.00
$10,500
Oct. 15
3,000
7.50
22,500
Total
4,500
$33,000
$71,500
(33,000)
$38,500
LIFO
Cost of goods available for sale (11,000 units)
Less: Ending inventory (determined below)
Cost of goods sold (difference)
Cost of ending inventory:
Date of
Purchase
Units Unit Cost Total Cost
Beg. inventory 4,000
$5.50
$22,000
January 17
500
6.00
3,000
Total
4,500
$25,000
$71,500
(25,000)
$46,500
Illustrations 8-7C, E, and G
T8-10 (continued)
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AVERAGE COST — PERPETUAL INVENTORY SYSTEM
Date
Purchased
Beginning
inventory
4,000 @$5.50 = $22,000
Jan. 10
Jan. 17
Sold
2,000 @$5.50 = $11,000
1,000 @ $6.00 = $6,000
Balance
4,000 @ $5.50
$22,000
2,000 @ $5.50
$11,000
$11,000+$6,000 =
$17,000
2,000+ 1,000 = 3,000 units
$17,000
= $5.667/unit
3,000 units
Mar. 22
3,000 @ $7.00 = $21,000
$17,000+$21,000 = $38,000
3,000+ 3,000 = 6,000 units
$38,000
= $6.333/unit
6,000 units
Apr. 15
Oct. 15
1,500 @$6.333 = $9,500
3,000 @ $7.50 = $22,500
4,500 @ $6.333 = $28,500
$28,500+$22,500 = $51,000
4,500+ 3,000 = 7,500 units
$51,000
= $6.80/unit
7,500 units
Nov. 20
3,000 @$6.80 = $20,400
Total cost of goods sold
4,500 @ $6.80
=
$30,600
= $40,900
Illustration 8-7D
T8-11
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FIFO — PERPETUAL INVENTORY SYSTEM

The same ending inventory and cost of goods sold amounts
are always produced in a perpetual system as in a periodic
system when FIFO is used.
Date
Purchased
Sold
Beginning 4,000 @ $5.50 = $22,000
inventory
Jan. 10
Jan. 17
Mar. 22
2,000 @ $5.50 = $11,000
1,000 @ $6.00 = $6,000
3,000 @ $7.00 = $21,000
Apr. 15
Oct. 15
1,500 @ $5.50 = $8,250
3,000 @ $7.50 = $22,500
Nov. 20
4,000 @ $5.50
$22,000
2,000 @ $5.50
$11,000
2,000 @ $5.50
1,000 @ $6.00
$17,000
2,000 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$38,000
500 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$29,750
500 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
3,000 @ $7.50
500 @ $5.50 +
1,000 @ $6.00 +
1,500 @ $7.00 = $19,250
Total cost of goods sold
Balance
1,500 @ $7.00
3,000 @ $7.50
$52,250
$33,000
= $38,500
Illustration 8-7F
T8-12
© The McGraw-Hill Companies, Inc. 2013
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LIFO — PERPETUAL INVENTORY SYSTEM
Date
Purchased
Sold
Beginning 4,000 @ $5.50 = $22,000
inventory
Jan. 10
Jan. 17
Mar. 22
2,000 @ $5.50 = $11,000
1,000 @ $6.00 = $6,000
3,000 @ $7.00 = $21,000
Apr. 15
Oct. 15
1,500 @ $7.00 = $10,500
3,000 @ $7.50 = $22,500
Nov. 20
4,000 @ $5.50
$22,000
2,000 @ $5.50
$11,000
2,000 @ $5.50
1,000 @ $6.00
$17,000
2,000 @ $5.50
1,000 @ $6.00
3,000 @ $7.00
$38,000
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
$27,500
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
3,000 @ $7.50
3,000 @ $7.50 = $22,500
Total cost of goods sold
Balance
2,000 @ $5.50
1,000 @ $6.00
1,500 @ $7.00
$50,000
$27,500
= $44,000
Illustration 8-7H
T8-13
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8-21
COMPARISON OF COST FLOW METHODS
The three cost flow methods are compared below assuming a
periodic inventory system.
AVERAGE
FIFO
LIFO
Cost of goods sold
$42,250
$38,500
$46,500
Ending inventory
29,250
33,000
25,000
$71,500
$71,500
$71,500
Total

During periods of generally rising costs FIFO cost of goods
sold results in a lower cost of goods sold than LIFO.

LIFO cost of goods sold will include the more recent higher
unit cost purchases.

FIFO ending inventory includes the most recent higher cost
purchases which results in a higher ending inventory than
LIFO.
T8-14
© The McGraw-Hill Companies, Inc. 2013
8-22
Intermediate Accounting, 7/e
LIFO CONFORMITY RULE

If a company uses LIFO to measure its taxable income, IRS
regulations require that LIFO also be used to measure income
reported to investors and creditors.

The LIFO conformity rule permits LIFO users to present
designated supplemental disclosures that report in a note the
effect of using another method on inventory valuation rather
than LIFO.
Inventories Disclosure — Rite Aid Corporation.
Summary of Significant Accounting Policies(in part)
Inventories
Inventories are stated at the lower of cost or market. The Company uses
the Last-in, first-out (LIFO) method of accounting for substantially all of
its inventories. At February 26, 2011 and February 27, 2010, inventories
were $875 million and $831 million, respectively, lower than the
amounts that would have been reported using the first-in, first-out
(FIFO) method.
Illustration 8-9
T8-15
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-23
LIFO LIQUIDATION PROFIT

A decline in inventory quantity results in LIFO liquidation
profit in periods of rising costs.
National Distributors, Inc., uses the LIFO inventory method. The
company began 2013 with inventory of 10,000 units that cost $20
per unit. During 2013 30,000 units were purchased for $25 each
and 35,000 units were sold.
National’s LIFO cost of goods sold for 2013 consists of:
30,000 units @ $25 per unit =
5,000 units @ $20 per unit =
35,000
$750,000
100,000
$850,000

Included in cost of goods sold are 5,000 units from beginning inventory
purchased at $20 that have now been liquidated.

If the company had purchased at least 35,000 units, no liquidation would
have occurred. Then cost of goods sold would have been $875,000 (35,000
units x $25 per unit) instead of $850,000. The difference between these two
cost of goods sold figures of $25,000 ($875,000 - 850,000) is the before tax
LIFO liquidation profit.

Assuming a 40% income tax rate, the net effect of the liquidation is to
increase net income by $15,000 [$25,000 x (1 - .40)].

A material effect on net income of LIFO layer liquidation must be disclosed
in a note.
Illustration 8-11
T8-16
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
INTERNATIONAL FINANCIAL REPORTING STANDARDS
Inventory Cost Flow Assumptions. IAS NO. 2 does not permit the use of LIFO.
Because of this restriction, many U.S. multinational companies employ the use of
LIFO only for all or most of their domestic inventories and FIFO or average cost for
their foreign subsidiaries. General Mills provides an example with a disclosure note
included in a recent annual report:
Inventories (in part)
All inventories in the United States other than grain are valued at the lower of cost,
using the last-in, first-out (LIFO method, or market… Inventories outside of the
United States are valued at the lower of cost, using the first-in, first-out (FIFO)
method, or market.
This difference could prove to be a significant impediment to U.S. convergence to
international standards. Unless the U.S. Congress repeals the LIFO conformity rule,
convergence would cause many corporations to lose a valuable tax shelter, the use of
LIFO for tax purposes. If these companies were immediately taxed on the difference
between LIFO inventories and inventories valued using another method, it would cost
companies billions of dollars. Some industries would be particularly hard hit. Most
oil companies and auto manufacturers, for instance, use LIFO. The government
estimates that the repeal of the LIFO method would increase federal tax revenues by
$59 billion over a ten-year period. The companies affected most certainly will lobby
heavily to retain the use of LIFO for tax purposes.
T8-17
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-25
DECISION MAKERS’ PERSPECTIVE —
SUPPLEMENTAL LIFO DISCLOSURES

Supplemental LIFO disclosures can be used to convert LIFO
inventory and cost of goods sold amounts.
Rite Aid Corporation
($ in millions)
Balance sheets:
Inventories
For the Year Ended
February 26,
February 27,
2011
2010
Income statements:
Net sales
Cost of goods sold

$505
9,516
6,613
6,401
4,431
Rite Aid Corporation uses the LIFO method to value its inventory. We can
convert Rite Aid's inventory and cost of goods sold to a FIFO basis before
comparing to a competitor by using the information provided in Illustration
8-11 (Slide T8-15).
($ in millions)
Inventories (as reported)
Add: Conversion to FIFO
Inventories (100% FIFO)

$474
2011
$3,158
875
$4,033
2010
$3,239
831
$4,070
Cost of goods sold for 2011 would have been $44 million lower had Rite Aid
used FIFO instead of LIFO for its LIFO inventories. While beginning
inventory would have been 831 million higher, ending inventory also would
have been higher by $875 million. An increase in beginning inventory causes
an increase in cost of goods sold, but an increase in ending inventory causes a
decrease in cost of goods sold.
T8-18
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
DECISION MAKERS’ PERSPECTIVE —
FINANCIAL ANALYSIS

The gross profit ratio indicates the percentage of each sales
dollar available to cover other expenses and provide a profit.

The inventory turnover ratio helps to evaluate a company's
effectiveness in managing its investment in inventory.
Gross profit ratio
=
Gross profit
Net sales
Inventory turnover ratio
=
Cost of goods sold
Average Inventory
T8-19
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-27
DOLLAR-VALUE LIFO (DVL)

Many LIFO applications are based on this approach.

Inventory is viewed as a quantity of value instead of a
physical quantity of goods.

The DVL inventory pool is viewed as comprising layers of
dollar value from different years.

An inventory pool is identified in terms of economic
similarity rather than physical similarity (subject to the same
cost change pressures).

DVL simplifies the recordkeeping procedures because no
information is needed about unit flows.

DVL minimizes the probability of the liquidation of LIFO
inventory layers, through the aggregation of many types of
inventory into larger pools.
T8-20
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
COST INDEXES

Under unit LIFO we determine whether a new LIFO layer
was added by comparing the ending quantity with the
beginning quantity.

Under DVL we determine whether a new LIFO layer was
added by comparing the ending dollar amount with the
beginning dollar amount.

However, if the cost level has changed, we need a way to
determine whether an increase observed is a real increase or
one caused by an increase in costs.

So before we compare the beginning and ending inventory
amounts, we need to deflate the ending inventory amount by
any increase in costs so that both the beginning and ending
amounts are based on the same level of costs.

We accomplish this by using cost indexes. A cost index for a
particular layer year is determined as follows:
Cost in layer year
Cost index in layer year =
Cost in base year

The cost index for the base year (the year DVL is initially
adopted) is set at 100.
T8-21
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-29
DVL ILLUSTRATION
Hanes Company adopted the dollar-value LIFO method on
January 1, 2013, when the inventory value was $400,000. The
2013 ending inventory valued at year-end costs is $441,000, and
the cost index for the year is 105.
Step 1: Convert ending inventory valued at year-end cost to base
year cost.
$441,000
Ending inventory at base year cost =
= $420,000
1.05
Step 2:
Identify the layers of ending inventory.
$420,000
400,000
$ 20,000
Step 3:
Ending inventory at base year cost
Beginning inventory, also at base year cost
Real increase in inventory quantity (new layer)
Convert each layer’s base year cost to layer year cost
using the cost index for the year it was acquired.
Date
1/1/13
12/31/13
Totals
Ending Inventory
at Base Year Cost x
$400,000
20,000
$420,000
Cost
Ending Inventory
Index = at DVL Cost
1.00
$400,000
1.05
21,000
$421,000
T8-22
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Suggestions for Class Activities
1.
Research Activity
Costco Wholesale Corporation (formerly Price/Costco) operates membership warehouses in 36
states, Puerto Rico, nine Canadian provinces, the United Kingdom, Korea, Japan, and Taiwan. It
offers very low prices on a limited selection of nationally branded and selected private label products
in a wide range of merchandise categories in no-frills, self-service warehouse facilities. Wal-Mart
Stores, Inc., the largest retailer in the U.S., is engaged in the operation of mass merchandising stores
located in all 50 states and a number of other countries. Have students, individually or in groups:
A. Access Walmart's most recent annual report using Edgar which can be located at www.sec.gov.
1. Determine the company's primary products and activities.
2. Using the data provided in the income statement and balance sheet,
determine what the company' cost of goods sold (cost of sales) for the
most recent year would have been if the company had used FIFO instead of
LIFO to value its inventories.
B. Access Costco's most recent annual report using Edgar.
1. Determine the company's primary products and activities.
2. Predict which company, Walmart or
ratio and the higher inventory turnover ratio.
Costco,
has
the
higher
gross
profit
3. Using the data provided in the income statements and balance sheets for the
most recent fiscal year, confirm their predictions in 2 above.
Points to note:
Students should predict a higher gross profit ratio and lower turnover ratio for Walmart. For the
2011 fiscal year:
Gross profit ratio
Inventory turnover ratio
Walmart
25%
9.13
Costco
11%
11.9
Be sure to point out the different strategies employed by the two companies. Walmart marks up
its product much more than Costco, but Costco turns its inventory much faster.
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-31
2.
Real World Activity
Deere & Company provides products and services primarily for agriculture and forestry. The
following disclosure notes appeared in the company’s financial statements for the six months ended
April 30, 2011:
Inventories:
Most inventories owned by Deere & Company and its U.S. equipment subsidiaries are valued at cost,
on the “last-in, first-out” (LIFO) basis. If all inventories had been valued on a “first-in, first-out”
(FIFO) basis, estimated inventories by major classification at October 31 in millions of dollars would
have been as follows:
April 30,
Oct. 31,
2011
2010
Raw materials and supplies
$
1,445 $
1,201
Work-in-process
625
483
Finished machines and parts
4,050
2,777
Total FIFO value
6,120
4,461
Less adjustment to LIFO value
1,433
1,398
$
4,687 $
3,063
Inventories
The company reported cost of goods sold of $10,201 million in its income statement for the six
months ended April 30, 2011.
Suggestions:
Have the class answer the following questions:
1. What would cost of goods sold for the six months ended April 30, 2011 have been if Deere
had used FIFO to value its entire inventory?
2. Using the reported numbers, what was Deere’s average days in inventory for the six months
ended April 30, 2011?
Points to note:
Cost of goods sold for the six months ended April 30, 2011 would have been lower by $35
million ($1,433 - $1,398) if Deere had used FIFO to value its entire inventory.
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
3.
Professional Skills Development Activities
The following are suggested assignments from the end-of-chapter material that will help your
students develop their communication, research, analysis and judgment skills.
Communication Skills. In addition to Communication Case 8-4, Communication Case 8-5 can be
adapted to ask students to write a memo to the "intern," and Communication Case 8-10 can be
adapted to ask students to write a memo to the "chief financial officer." Ethics Case 8-7 does
well as a group assignment. Judgment Case 8-1 and Real World Case 8-8 create good class
discussions. Real World Case 8-8, Research Case 8-11, and Analysis Case 8-12 are suitable for
student presentation(s).
Research Skills. In their careers, our graduates will be required to locate and extract relevant
information from available resource material to determine the correct accounting practice,
perhaps identifying the appropriate authoritative literature to support a decision. Research Case
8-11 and Exercises 8-12 and 8-20 provide excellent opportunities to help students develop this
skill. In addition, Real World Case 8-8 can be adapted to require students to research the
authoritative literature on the presentation of supplemental LIFO disclosures.
Analysis Skills. The “Broaden Your Perspective” section includes Analysis Cases that direct
students to gather, assemble, organize, process, or interpret data to provide options for making
business and investment decisions. In addition to Analysis Case 8-12, Exercise 8-21, Problems
8-6, and 8-9; Judgment Case 8-1 and Real World Case 8-9 also provide opportunities to
develop and sharpen analytical skills.
Judgment Skills. The “Broaden Your Perspective” section includes Judgment Cases that require
students to critically analyze issues to apply concepts learned to business situations in order to
evaluate options for decision-making and provide an appropriate conclusion. In addition to
Judgment Cases 8-1, 8-3, and 8-6, Ethics Case 8-7 also requires students to exercise judgment.
CPA Simulation. Students can test their knowledge of the concepts discussed in this chapter and
at the same time practice critical professional skills necessary for career success and
preparation for the computer-based CPA Exam. The simulation for this chapter, Johnson
Company, tests students’ knowledge of the physical quantities and costs that should be
included in inventory. Access the simulations at the text website: www.mhhe.com/spiceland7e.
Instructors Resource Manual
© The McGraw-Hill Companies, Inc. 2013
8-33
Assignment Chart
Questions
8-1
8-2
8-3
8-4
8-5
8-6
8-7
8-8
8-9
8-10
8-11
8-12
8-13
8-14
8-15
8-16
Learning
Objective(s)
3
1
1
2
2
3
1,3
4
4,5
5
6
7
8
8
8
9
Est. time
Topic
(min.)
Types of inventory for a manufacturer
5
Perpetual versus period inventory systems
5
Perpetual versus period inventory systems
5
F.O.B. shipping point versus F.O.B. destination
5
Consignment arrangement
5
Purchase discounts; gross versus net methods
5
Periodic inventory system
5
Inventory costing methods
5
LIFO versus FIFO
5
LIFO
5
IRS conformity rule
5
Ratios used to monitor investment in receivables 5
LIFO inventory pool
5
Dollar-value LIFO compared with unit LIFO
5
Dollar-value LIFO
5
IFRS; inventory valuation methods
5
Brief
Exercises
8-1
8-2
8-3
8-4
8-5
8-6
8-7
8-8
8-9
8-10
8-11
8-12
8-13
Learning
Objective(s)
1
1
2
3
3
4
4
4
4
6
6
7
8
Est. time
Topic
(min.)
Determining ending inventory; periodic system
5
Perpetual system; journal entries
5
Goods in transit
10
Purchase discounts; gross method
10
Purchase discounts; net method
10
Inventory cost flow methods; periodic system
15
Inventory cost flow methods; perpetual system
15
LIFO method
10
LIFO method
10
LIFO liquidation
10
Supplemental LIFO disclosures; SuperValue
10
Ratio analysis
10
Dollar-value LIFO
10
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Exercises
8-1
8-2
8-3
8-4
8-5
8-6
8-7
8-8
8-9
8-10
8-11
8-12
8-13
8-14
8-15
8-16
8-17
8-18
8-19
8-20
8-21
8-22
8-23
8-24
CPA/CMA
Exam Questions
CPA-1
CPA-2
CPA-3
CPA-4
CPA-5
CPA-6
CPA-7
CPA-8
CMA-1
CMA-2
CMA-3
Instructors Resource Manual
Learning
Est. time
Objective(s)
Topic
(min.)
1
Perpetual inventory system; journal entries
10
1
Periodic inventory system; journal entries
10
1
Determining cost of goods sold; periodic
inventory system
15
1
Perpetual and periodic inventory systems
compared
15
1
Periodic inventory system; missing data
25
2
Goods in transit
10
2
Goods in transit; consignment
10
Physical
quantities
and
costs
included
in
2
10
inventory
3
Purchase discounts; the gross method
15
3
Purchase discounts; the net method
15
3
Trade and purchase discounts; the gross method
and the net method compared
20
2,3
FASB codification research
20
1,4
Inventory cost flow methods; periodic system
20
1,4
Inventory cost flow methods; perpetual system
25
1,4
Comparison of FIFO and LIFO; periodic system 20
1,4
Average cost method; periodic and perpetual
systems
20
1,4
FIFO, LIFO, and average cost methods
20
6
Supplemental LIFO disclosures; LIFO reserve;
Steelcase
15
1,4,6
LIFO liquidation
10
6
FASB codification research
20
7
Ratio analysis; The Home Depot and Lowe’s
15
8
Dollar-value LIFO
20
8
Dollar-value LIFO
25
1,2,3,4,5 Concepts; terminology
15
Learning
Objective(s)
2
3
4
4
4
4,5
8
9
1,4
1,4
1,4
Est. time
Topic
(min.)
Goods in transit
3
Purchase discounts; the net method
3
Inventory cost flow methods; periodic system
3
Inventory cost flow methods; periodic system
3
Inventory cost flow methods; periodic system
3
FIFO vs. LIFO
3
Dollar-value LIFO
3
IFRS
3
FIFO; perpetual
3
LIFO; periodic
3
LIFO; perpetual
3
© The McGraw-Hill Companies, Inc. 2013
8-35
Problems
8-1
8-2
8-3
8-4
Learning
Objective(s)
1,2,3
2
2,3
1,2,3,4
8-5
8-6
1,4
1,4,7

8-7
8-8
8-9
8-10
8-11
1,4
4,6
4,6
4,6
4,6,7

8-12
4,6,7

8-13
8-14
8-15
8-16
8
8
8
8

Est. time
Topic
(min.)
Various inventory transactions; journal entries
45
Items to be included in inventory
20
Costs included in inventory
25
Various inventory transactions; determining
25
inventory and cost of goods sold
Various inventory costing methods
50
Various inventory costing methods; gross profit
ratio
40
Various inventory costing methods
40
Supplemental LIFO disclosures, Caterpillar
20
LIFO liquidation
20
LIFO liquidation
25
Inventory cost flow methods; LIFO liquidation;
ratios
30
Inventories and accounts receivable; Chapters 7
and 8
25
Dollar-value LIFO
25
Dollar-value LIFO
25
Dollar-value LIFO
25
Dollar-value LIFO; solving for unknowns
25
 Star Problems
© The McGraw-Hill Companies, Inc. 2013
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Intermediate Accounting, 7/e
Cases
Judgment Case 8-1
Real World Case 8-2
Judgment Case 8-3
Communication Case 8-4
Communication Case 8-5
Judgment Case 8-6
Ethics Case 8-7
Real World Case 8-8
Real World Case 8-9
Communication Case 8-10
Research Case 8-11
Analysis Case 8-12
Air France-KLM Case
CPA Simulation 8-1
Instructors Resource Manual
Learning
Est. time
Objective(s)
Topic
(min.)
7
Riding the Merry-Go-Round
25
Physical quantities and cost included in
2
35
inventory; Sport Chalet
The specific identification inventory method;
3,4
30
inventoriable costs
4,5
LIFO versus FIFO
45
4,5
LIFO versus FIFO
15
2
Goods in transit
15
4
Profit manipulation
30
4,6
Effects of inventory valuation methods: LIFO
and FIFO; The Kroger Company
25
4,5,7
Effects of inventory valuation methods; Whole
Foods Market
45
8
Dollar-value LIFO method
20
2,3
FASB codification research; product financing
arrangement
40
7
Compare inventory management using ratios;
Saks and Dillards
60
9
IFRS; inventory valuation methods; Air FranceKLM
15
Physical quantities and costs included in inventory
© The McGraw-Hill Companies, Inc. 2013
8-37